In quite general terms, the use of the rental capitalization method for the valuation of an income producing property is based on the rental value of the property capitalised by the appropriate rate (cap rate) based on the yield.

CYPRUS has had an increase in property rental prices (an issue which is largely discussed throughout media these days) during the last few months. During the same period, there are quite a few properties available in the market with more expected (due to obvious crisis reasons the last few years which may be discussed in another post) which are usually available for sale by the various institutions, agents, owners etc.

OK, so people were having difficulties buying houses/flats so they had to rent so there was an upward demand for rents so the rents increased etc. (simple demand/supply trends)….. So anyway, the rents are up… for now!

Using the rental income to value a property will take the yearly market rent (NOI) and capitalise it by the appropriate rate to come up with the market value of the property. By the way, I see a lot of adverts/marketing by some so called “property consultants” who market properties stating the ‘return on investment’ based on the yearly ‘gross rent’ divided by the ‘asking price’.…… Sorry guys… it’s the “net operating income” divided by the “market value/selling price” of the property to come up with the actual return percentage….. as Bon Jovi once said… “you give love a bad name”….. I understand this may be a lower percentage compared to your advert/marketing you state but I believe it is only fair that your clients know the actual return they will be receiving on their investment…. So please stop giving us a bad name!!

Back to rents and the property value…. If rents are currently considered to be at high levels, obviously valuing a property based on the rent will show an increase in the market value of the property (although supply of properties for sale is expected to increase).

Example: Say we have a property with an annual NOI of €10,000 and a market value/selling price of €100,000 the return is calculated at 10%. (i.e. €10,000/€100,000 = 10% Return).

So how safe is your €10,000 at this point? Will the investor/owner continue to receive €10,000 of rental income in the next few months/years? As mentioned above, rents are already considered to be at high levels. Is 10% considered a high return on investment for a relatively low risk 1-bedroom apartment, say, in a city centre (yields are much lower in the city centre by the way). So anyway….. quite unreasonable for a low-risk investment to receive a 10% return. If an investor expects a 10% on a 1-bedroom apartment in the city centre then what return would he expect on a hotel investment based on the high risk taken?

Let’s take it at an even simpler level…. what will happen to the return once the market values are increased? Well…it decreases! Or, what would happen to the return once the rents are decreased, say… hmm at normal equilibrium market rental levels…Well, once your NOI goes down to market rent (e.g. say €5,000 per year) you automatically have a return decreased to 5% (…explain that to your client mr. salesperson).

So you got your €10,000 rent, you got your 10% return….. enough info to get a market value of €100,000 (i.e. 10,000* cap rate of 10% = €100,000). But we already know the rent is very high…. so you probably won’t be receiving it for too long once the rents decrease, right?…. So let’s do some forecasting…. €10,000 will probably decrease…. and if the rent is decreased and the investor is aiming for a 10% return then his solution would probably be to negotiate the “asking price” marketed by that same salesperson or so called “property consultant” who is still insisting to market the property as a “great investment”!!

Point being….. Rents are high at the moment….. this drives market values up…during this same period supply of “for sale properties” is increasing…. Do the forecast!!

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Readers' comments

Well said, so maybe Gross Rental Yield (GRY) could be the appropriate term to be used. I guess if we started using discount Rates to account for the opportunity cost of the capital investment, we would probably end up half of the 5%. I guess gross rental income yields would be most appropriate for property consultants (property agents to be exact).

Property Agents or better Property Sales Agents can get away with GRY…. whilst valuers will have to be more explicit as you pointed out quite accurately!

I guess Sales (selling) is an Art ? too! :)

The views expressed in readers' comments are not necessarily shared by the Cyprus Property News.

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